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Seeking Guides for the Financial Markets

(November 10, 2005)

Dear Subscribers and Readers,

In last weekend's commentary, we discussed how and why retail investors are usually great contrarian indicators and how they have "shown their hands" with regards to their current views of the yield of the 30-year U.S. Treasury Bond.  Quoting from our last commentary: "In other words, revealing one's hand in the markets is usually a death sentence - especially if one usually does not have the ability to ride out those positions.  Such is the case usually with the positions of retail investors - who are inherently emotional and who usually has the least ability to hold on to a position - which leads to the heart of today's commentary." As a result, this author is now gearing to purchase some long-dated government bonds for his own portfolio - hoping to be one of the few investors who can profit from the emotional swings of individual investors.

So, a question for you Henry: In order to make money consistently, is it simply as easy as being a contrarian and simply taking the opposite side of what retail investors are trading?  My answer to this is "yes" and "no."

I apologize for the vague answer, but long-time readers and experienced investors should realize that when it comes to the financial markets, the best investment is usually only obvious in retrospect - and that even when all the research in the world argues for making a particular investment (such as stocks in 1982, gold in late 2000, or the U.S. Dollar earlier this year), it is always psychologically difficult to make those investments at that point in time - as prevailing sentiment are always overwhelmingly against you.  That's the reason why one should always do his or her own research when it comes to the financial markets, since when push comes to shove, one can only hold on to his or her position if one has the confidence in those positions.  Adopting other people's viewpoints (even ours) will not suffice.  That is the reason why I have emphasized in the past that our commentaries should only act as a starting point for further research - or as a basis for sound investing or speculation (if there is such a thing).  That being said, sometimes, it is not too difficult to detect potential profit opportunities.  Readers who have kept track of the magazine covers of Time Magazine or Newsweek over the years will know what I mean.

Okay Henry, that is easier said than done.  How should I start my research on the financial markets - or better yet, how can I guide myself through the markets, as opposed to being at the mercy of the popular media?  Dear readers, this is where our commentaries come in.  And believe me, writing this commentary is every bit as important for us as well.  Like I mentioned before, our commentaries should only be used as a starting point for further research, but another purpose of our research is help our readers (and ourselves) objectively analyze the market on at least a weekly basis.  This will help remove the emotions of everyday investing - especially for those who watch CNBC on a regular basis!

When we first began our commentary, our intention was to incorporate a discussion of Dow Theory in most of our commentaries - but over the last 18 months, it has become blatantly obvious that it would be difficult to discuss the Dow Theory on a weekly basis, even though the Dow Theory is a relatively broad topic (encompassing all aspects of investing such as valuations, cycles, technical analysis, etc.) and is very flexible in terms of interpretation.  Moreover, in order to gain an edge on other investors, it is always wise to review, revise, and create new indicators - which so far we have attempted to do in most of our commentaries.  That being said, subscribers should keep in mind that the Dow Theory has withstood the test of time - and while it is not of much use in everyday trading, it has, in the past, provided very strong warning signals as well as signals indicating an imminent bottom.

Let me illustrate further.  There is a strong chance that we are now in a secular bear market.  In fact, history is telling us that we are now in a secular bear market.  I am not going into any further details, since we have previously discussed why.  If so, then we are in the midst of a cyclical bull market that will end sooner or later - and my guess is sooner since the stock market rally from October 2002 is about as strong as cyclical bull markets (within the context of a secular bear market) have been in the past.  For older subscribers and readers who have studied stock market history, you may also recall that the U.S. last experienced a secular bear market during the 1966 to 1974 period.  Within the context of the 1966 to 1974 secular bear market, there were two cyclical bull markets - one lasting from October 1966 to December 1968 and the other lasting from May 1970 to January 1973.  Interestingly, the tops in both of these cyclical bull markets were immediately preceded by a PRIMARY non-confirmation of one Dow Jones index by another.

In the October 1966 to December 1968 cyclical bull market, a PRIMARY Dow Theory non confirmation occurred in December 1968 when the Dow Transports made an all-time high while the Dow Industrials failed to concurrently make an all-time high (the Dow Industrials was ten points away from surpassing its all-time high of 995.20 made in February, 1966).  Over the next two months, the Dow Transports experienced a consolidation phase while the Dow Industrials significantly.  For followers of the Dow Theory, this was a grave enough warning, and over the next 15 months, the Dow Industrials would decline by 33% while the Dow Transports would decline by over 50%.

In the May 1970 to January 1973 cyclical bull market, a PRIMARY Dow Theory non confirmation occurred in January 1973 when the Dow Industrials made an all-time high while the Dow Transports failed to concurrently make an all-time high (nine months earlier, the Dow Transports was 3.8 points away from surpassing its all-time high of 279.5 made in December 1968).  This time, the Dow Transports severely lagged the Dow Industrials over the last nine months prior to January 1973 - which proved to be the precursor to the brutal 1973 to 1974 bear market.  Over the next 22 months, the Dow Industrials would decline by 45% while the Dow Transports would again decline by over 50%.

For readers who have followed my commentaries over the last 12 months, it is obvious that the Dow Industrials have been severely lagging.  In fact, the Dow Transports made another all-time closing high today (at 4,004.37), while the Dow Industrials failed - not only to surpass its all-time high, but also its last major high of 10,940.55 made at the close on March 4, 2005.  As of this writing, the Dow Industrials is still 394.34 points away from surpassing that last major high.  Under the Dow Theory, the underperformance of the Dow Industrials over the last 22 months and the failure of the Dow Industrials to confirm the Dow Transports on the upside is ominous, and in this author's opinion, carries significant bearish implications.

Of course, such a statement will carry no significance with our readers if it was made in a vacuum.  Readers should note that the basis of the Dow Theory is values.  This has been reflected in all the writings of the most successful Dow Theorists, and is nicely summed up by Charles H. Dow himself when he said (over a hundred years ago): "When a stock sells at a price which returns only about 3 ½ percent on the investment, it is obviously dear, except there be some special reason for the established price.  In the long run, the prices of stocks adjust themselves to the return on the investment and while this is not a safe guide at all times it is a guide that should never be laid aside or overlooked.  The tendency of prices over a considerable length of time will always be toward values."

Over the long-run, this author has found the Dow Theory to be a very useful long-term guide post.  Now that we are on the subject of valuations, we should ask: What is the valuation of the market and what is it telling us now?  Let's take a look by looking at the historical P/E ratio of the S&P 500.  Following is a long-term monthly chart of the P/E of the S&P 500 from 1925 to October 2005, courtesy of

Long-term monthly chart of the P/E of the S&P 500 from 1925 to October 2005

As the history of the stock market shows, the valuation of the general market has historically fluctuated between an undervalued condition (with a P/E of 10) and an overvalued condition (with a P/E of 20).  Today's P/E of the S&P 500 is at 19.26 - which is historically overvalued.  In a paper published during March 2001 (thanks to Bill and Victor for the link), Robert Shiller and John Campbell argued that the popular valuation ratios such as the price-to-earnings and price-to-dividends ratios have been very reliable historically in predicting future stock prices (on a general basis) - using U.S. data from 1871 to 2000 and data for 12 other countries from 1970 to 2000.  Under the Dow Theory, this is obviously true as well.  Readers who have followed the Fed model may be surprised, but in analyzing future predicting power, both Shiller and we are strictly using P/E and P/D ratios only.  That is, we do not take the prevailing interest rates into account.  In fact, history has shown that the best time to buy stocks is when interest rates are high - not low as they are now (unless real interest rates sky-rocketed similar to what we saw during the first few years of the Great Depression).  The fact that stocks are now overvalued on a historical basis further cements the validity of the current PRIMARY non-confirmation of the Dow Transports by the Dow Industrials.

Of course, our "guide posts" to the stock market are not strictly limited to a discussion of the Dow Theory.  In previous commentaries, we have discussed technical indicators such as the NYSE ARMS Index, the NYSE McClellan Oscillator and Summation Index, the equity put/call ratios, and the VIX.  We have also discussed our own proprietary and other fundamental models, such as our MarketThoughts Global Diffusion Index, our MarketThoughts "Excess M" Indicator, the NYSE and NASDAQ short interest, and the total amount of margin debt outstanding on both the NYSE and the NASDAQ.

In this commentary, I would like to update our readers our thoughts on our MarketThoughts "Excess M" Indicator, or MEM for short.  Readers who would like a detailed discussion of our MEM Indicator can go back and read our October 23rd commentary as well as our October 30th commentary.  Following is a direct quote from our October 30th commentary explaining the meaning behind our MEM Indicator: In last week's commentary, we first introduced our "MarketThoughts Excess M" indicator (the "MEM indicator").  "Basically, it works like this: Whenever our MEM indicator declines below the zero line, there is a lack of "excess cash" in the domestic economy, and vice-versa.  The "lack of excess cash" indicates that the turnover of money is high (also known as velocity) - indicating that investors are "risk seeking" as opposed to being risk adverse.  This is important - as excess speculation in an economy makes it more prone to a slowdown or a recession, especially given that the bull cycles in commodities, real estate, and the stock market are now getting very mature." .  In a sense, our MEM Indicator (the 52-week growth rate of the adjusted monetary base minus the 52-growth rate of M-3 - all smoothed using their ten-week moving averages) gives us one of the purest measurements for financial velocity - even more so than the traditional velocity measurement of GDP/M-3 (or M-2).  Why?  Because when speculative activity in the financial world increases, this is directly reflected in the M-3 numbers.  Monetary aggregates such as the adjusted monetary base and M-3 can be reasonably measured.  The GDP number, meanwhile, is not a number that can be easily measured.  In fact, the GDP number is only a guesstimate- and is subjected to government adjustments nearly all the time.

However, it is important to keep in mind that our MEM Indicator does not capture the individual direction of the monetary base or M-3.  Instead, it only measures the difference between the monetary base and M-3.  Let's now break the components down.  Following is a modified chart of our prior MEM chart.  This one shows our MEM Indicator as well as the 52-week change in the monetary base and M-3:

The MarketThoughts Excess M Indicator vs. Monetary Base vs. M-3(February 1985 to Present) - Speculators continues to be aggressive in the face of the Fed reining in the monetary base.  Our MEM indicator stretched further to the downside last week from negative 3.43% to negative 3.66% - the lowest since Jan 2002.  This does not bode well for the markets going forward. 4) Markets did well during the 1995 to 1998 - despite a decline in the monetary base and immense speculation - primarily because of the Yen carry trade!  But now, the BoJ is tightening as well...

Please note that our MEM Indicator is now at its lowest level since January 2002 - and readers should remember what happened six months afterwards!  Right now, investors and speculators alike are still choosing to go with their "animal spirits" (rising M-3) - totally ignoring the Fed and actually fighting it (declining monetary base).  Of course, this does not mean the stock and commodity markets will tank tomorrow, but if current liquidity trends continue, that this could mean trouble for the major markets within the next three to six months. Now, using the above and the prior logic we have developed, we get the following guide post:

Guide post

This guide post (along with a six-year history of it) using monetary indicators is invaluable.  Based on this guidepost, readers should realize that we are now in dangerous territory.  In fact, based on the recent directions and movements of the monetary base and M-3, we are now in territory (tighter liquidity but people more willing to speculate than ever before) not seen since early 2000.  I will provide a better explanation of this guide post in this weekend's commentary.

Finally, in light of the recent decline in the Japanese Yen, many investors are now wondering if the Yen carry trade is alive and well.  If so, then this could mean liquidity is flowing from Japan to the United States, which could further extend the life of this cyclical bull market. While there is a chance this is happening, this author does not think so - at least not on a significantly large scale.  Please keep in mind that while the 1995 to 1998 Yen carry trade lasted for approximately three years; it only took six weeks to unwound - with the Yen appreciating a whopping 30% in the process!  No doubt, many investors and hedge funds got burnt, so it is doubtful whether that is happening on a large scale once again - and so soon.  Moreover, the recent monetary growth in Japan does not seem to support such a trade on a large scale:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly)(January 1991 to October 2005) - 1) Note that Japanese money growth has been plunging since the end of 2003 although for the YoY growth has perked back up slightly to 2.84% as of October.  Such dismal growth, however, will not support another yen carry trade. 2) Note that the second derivative (the rate of growth of the Japanese monetary base) is still in negative territory - although it turned up quite a bit since February.

Please note that while the year-over-year growth in the Japanese monetary base has increased slightly to 2.84%, it is very doubtful in this author's mind whether the Yen carry trade can again occur in the face of such dismal monetary growth.  For comparison purposes, the annual growth of the monetary base was in the 3.75% to 10.00% range during the 1995 to 1998 period.

Conclusion: When it comes to evaluating and trying to profit from a "complicated beast" such as the U.S. stock and financial markets, it is essential that we have the necessary guide posts to lead us.  Just like the moral compass that (hopefully) each of us abide by, these guide posts need to be objective, logical, and time-tested.  The Dow Theory as originated by Charles Dow and interpreted by Theorists such as William Hamilton, Robert Rhea, E. George Schaefer, and Richard Russell fits this bill.  However, it is always important to find and maintain our edge over other investors, and that is why we are constantly reviewing, revising, and coming up with new indicators.  Both our MarketThoughts Global Diffusion Index and our MarketThoughts "Excess M" Indicator fit this bill as well.

In most likelihood, the stock market achieved a significant, short-term bottom a couple of weeks ago, but at the same time, our current indicators are telling us that the cyclical bull market is maturing and most probably nearing an end.  If current trends continue, then I would give this cyclical bull market another three to six months, at the most.  For now, while the short-term environment is still okay to speculate with, it should be noted that having the necessary stock-picking skills is also of paramount importance, given how divergent many of the stock market sectors have been.  Extreme caution is still warranted.

Signing off,

Henry K. To, CFA

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